WSM | Key Takeaways From The Print

Takeaway:Limited sq. ft. growth. Declining EPS growth rate and returns coming down. Tough to find a reason to own this name at 23.5x earnings.

Overall, not an impressive quarter for WSM. EPS was about in-line, but the company got there in a low-quality way. We have a hard time laying out a bull case on this one – as it has virtually no square footage growth in any concept except West Elm, and even that leaves us with consolidated growth of less than 3%. WSM has proven grossly incapable of improving its operating margin over the last three years, with annual margin sitting right in line with where it was at pre-recession peaks. So why own it? Cash flow margin is reasonably healthy, but the current stock repo rate is driving about 300bp in earnings growth. Nice, but nothing to write home about. In the end, we have a hard time building up to a double digit EPS growth rate in our model, and it comes with declining returns. Tough to find a reason to own this name at 23.5x earnings.

What We Liked

1) Top line – though every concept decelerated sequentially on a 2yr basis except for PB Kids (flat) the company beat lowered expectations by 200bps or $19mm. 25-50% of this was due to the guided port strike revenue issues ($5-$10mm) which didn’t materialize during the quarter (sandbag?). That’s good news for RH who a) isn’t reliant like WSM on seasonal merchandise and b) product flow should start to normalize.

2) West Elm continued to hum along with a 15.7% comp in the quarter. To be fair that was a 90bps deceleration sequentially in the underlying trend, but it’s been a fairly good barometer for RH over the past few quarters and the current consensus numbers assume that West Elm outperforms RH in the numbers the company will report in 2 weeks. West Elm has only outcomped RH twice since 2012 in 1Q14 and 2Q14 when the company changed up its source book strategy. We expect to see a bifurcation in growth trends as RH top line growth accelerates in back half of the year as it rolls out Modern and Teen.

3) Unit growth accelerated to 32.9% at the West Elm concept (3.2% for the company) – the highest growth rate for West Elm since 1Q09 and the company will add another 9 units before the year is over. The runway for growth appears to be running out with new doors in Grand Rapids, MI, Rochester, NY, and Charleston, SC not what we could consider ‘A’ MSAs.

What We Didn’t Like

1) Last quarter was the first time in the past 17 that WSM had printed down EBIT growth YY. At that point in time the company attributed all of that loss and then some to the port delay issues. 2Q15 marks the 2nd quarter in a row where EBIT was down and Earnings growth was made up entirely by tax rate (which wasn’t assumed in the company’s guidance). The port strike negatively affected EBIT by 50bps and pressured earnings by ~$0.04 and increased labor hours added another ~30bps of pressure.

2) Op margins were down for the 2nd straight quarter and are guided to a range of 10.2%-10.5% for the year. We give the company credit for being able to offset 8 straight quarters of gross margin declines headed into this fiscal year and still hit a peak EBIT margin of 10.5%. That trend has continued into FY15 and now the company is going back into investment mode (i.e. less SG&A leverage) as it continues to rejigger its e-comm capabilities and clean up its supply chain. Some of the port related costs roll off after we clear 3Q. But, WSM operates at a 10.5% EBIT margin under the BEST conditions, i.e. mid to high singled digit comp growth. What happens when the top line slips to the LSD?

3) The company guided the mid-point of the 3Q range 6% below street expectations implying an earnings growth rate of flat to +7% on 4-6% comps and 6.5% revenue growth. Not heroic by any stretch, but the company needs to prove that it can offset added cost pressures on both the GM and SG&A lines from lingering port issues and investments. For the full year we need to assume that margins get back to flat or +50bps to hit the 10.2% -10.5% range for the year after a 70bps contraction in 1H. We have a hard time getting comfortable with that.

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08/27/15 08:57 AM EDT

FLASHBACK | Tiffany's $TIF: We Don’t Like It

This is a brief excerpt from a research note published Tuesday night by our retail team ahead of this morning's print. Tiffany shares were down -5% as of this posting. If you would like more info on how you can subscribe to our institutional research please email sales@hedgeye.com.

We don’t like Tiffany & Co. TIF into the print as we think 1) back half numbers look too high, and 2) this model is extremely poorly positioned for the consumer climate we’re forecasting. There are definitely redeeming qualities about the name – most notably the Brand (and that’s pretty much it). But it is trading near a peak multiple (18.5x) on peak margins (21%), peak earnings ($4.24E), peak returns (18%), has the worst cash conversion cycle we’ve ever seen (490 days), while sentiment is sitting at all-time highs. It’s feast or famine – if one of those metrics breaks, then they all do.

Common perception seems to be that “just because TIF blew up earlier this year, it can’t blow up again.” We simply disagree. The environment has changed significantly, and the company’s guidance for back half growth “in the double digits” is not going to happen. Could the company grow earnings in the 4-6% range? Yes. It can. But that implies at least a $0.15 guide down. Importantly, that could/should cause the consensus to revisit its $4.75 estimate for next year, which we don’t think is achievable. We think a base case is $4.50, with downside to $4.00 as the macro environment worsens.

Historically, TIF’s multiple change has been fairly explosive. As you can see, when earnings have been revised meaningfully up or down, we’ve seen TIF’s multiple relative to the S&P move by up to 40%. The point is that a $4.00 earnings number won’t get a high-teens multiple. It will get something in the low teens while the market waits for earnings to find a bottom. Using that logic, it is not unrealistic to model a $50 stock -- $30 lower. Are we making a call right now for such severe downside? No, we’re not. But that’s where the research initially appears to be headed.

Mother Macro Could Make $4.00 (or less) A Reality?

Consider the following… Domestic economic growth is now well past-peak in rate-of-change terms for this economic expansion, with US GDP growth getting tougher in the 2nd half of 2015 vs. the 1st half. That means, if you held all other risks equal, the probability is higher that growth slows in Q3 and Q4 than Q2. And the last two cycle tops didn’t have this mother of all demographic secular slowings – and note that this isn’t just the US -- the chart below represents better than 90% of Tiffany’s earnings.

Modeling Considerations

2Q: Overall, 2Q looks ok to us. Street estimates imply a slowdown in the 2 year constant currency comp by ~200bps. That seems fair. LVMH and Kering both noted rebounds in jewelry sales in their second quarters. Additionally, TIF's comp has directionally followed the organic growth of LVMH watch and jewelry sales for the past 4 quarters. A potential positive is the Tiffany T collection which could/should boost penetration of the higher margin gold/silver fashion product. TIF’s US e-commerce business implies healthy demand in 2Q – though the trends look problematic into 3Q. It’s only 6% of TIF’s business, but is a good barometer for overall demand. Furthermore, TIF’s SIGMA chart looks very bad. Inventories are out of whack with the P&L in a way that is unlikely to be a 1-quarter fix without a meaningful margin event.

Ping our sales team for more info on our research.

ICI Fund Flow Survey | Not the Longest But the Fastest

Takeaway:At 25 weeks, the current streak of domestic equity outflows isn't the longest, but it is the fastest at an avg of -$4 billion per week lost

Investment Company Institute Mutual Fund Data and ETF Money Flow:

Domestic equity funds continue their streak of outflows, now at 25 consecutive weeks with another -$5.2 billion reigned in by investors in the most recent 5 days. The table below shows all domestic equity outflow sequences greater than 4 consecutive weeks in data going back to 2008. We considered a streak of outflows broken by 4 weeks of consecutive inflows. Within these parameters, there have been 8 total outflow sequences with the mean lasting 40 weeks with $105 billion lost on average. The current sequence, as of August 19th, is only the 8th longest in weekly duration, but at -$101.0 billion in total outflows lost, it is the 4th largest in magnitude. With an average outflow of -$4.0 billion per week, the running 2015 outflow is fastest pace on record in our data back to '08.

In other products, intermediate trends continued with investors fleeing fixed income given worries over the direction of short-term interest rates. In the most 5 day period, investors pulled -$1.3 billion from total bond mutual funds and ETFs with these withdrawals continuing to fund international equity investments. This week international funds took in +$4.7 billion, their largest inflow since +$5.0 billion in the week ending April 18th, 2007.

In the most recent 5-day period ending August 19th, total equity mutual funds put up net outflows of -$554 million, trailing the year-to-date weekly average inflow of +$70 million and the 2014 average inflow of +$620 million. The outflow was composed of international stock fund contributions of +$4.7 billion and domestic stock fund withdrawals of -$5.2 billion. International equity funds have had positive flows in 48 of the last 52 weeks while domestic equity funds have had only 9 weeks of positive flows over the same time period.

Fixed income mutual funds put up net outflows of -$2.3 billion, trailing the year-to-date weekly average inflow of +$1.2 billion and the 2014 average inflow of +$926 million. The outflow was composed of tax-free or municipal bond funds contributions of +$50 million and taxable bond funds withdrawals of -$2.3 billion.

Equity ETFs had net redemptions of -$238 million, trailing the year-to-date weekly average inflow of +$2.2 billion and the 2014 average inflow of +$3.2 billion. Fixed income ETFs had net inflows of +$968 million, outpacing the year-to-date weekly average inflow of +$814 million but trailing the 2014 average inflow of +$1.0 billion.

Mutual fund flow data is collected weekly from the Investment Company Institute (ICI) and represents a survey of 95% of the investment management industry's mutual fund assets. Mutual fund data largely reflects the actions of retail investors. Exchange traded fund (ETF) information is extracted from Bloomberg and is matched to the same weekly reporting schedule as the ICI mutual fund data. According to industry leader Blackrock (BLK), U.S. ETF participation is 60% institutional investors and 40% retail investors.

Most Recent 12 Week Flow in Millions by Mutual Fund Product: Chart data is the most recent 12 weeks from the ICI mutual fund survey and includes the weekly average for 2014 and the weekly year-to-date average for 2015:

Cumulative Annual Flow in Millions by Mutual Fund Product: Chart data is the cumulative fund flow from the ICI mutual fund survey for each year starting with 2008.

Most Recent 12 Week Flow within Equity and Fixed Income Exchange Traded Funds: Chart data is the most recent 12 weeks from Bloomberg's ETF database (matched to the Wednesday to Wednesday reporting format of the ICI), the weekly average for 2014, and the weekly year-to-date average for 2015. In the third table are the results of the weekly flows into and out of the major market and sector SPDRs:

Sector and Asset Class Weekly ETF and Year-to-Date Results: In sector SPDR callouts, investors contributed a massive +9% or +$448 million to the long treasury TLT ETF as they sought safety on Chinese and global growth concerns.

Cumulative Annual Flow in Millions within Equity and Fixed Income Exchange Traded Funds: Chart data is the cumulative fund flow from Bloomberg's ETF database for each year starting with 2013.

Net Results:

The net of total equity mutual fund and ETF flows against total bond mutual fund and ETF flows totaled a positive +$524 million spread for the week (-$792 million of total equity outflow net of the -$1.3 billion outflow from fixed income; positive numbers imply greater money flow to stocks; negative numbers imply greater money flow to bonds). The 52-week moving average is +$2.0 billion (more positive money flow to equities) with a 52-week high of +$27.9 billion (more positive money flow to equities) and a 52-week low of -$18.1 billion (negative numbers imply more positive money flow to bonds for the week.)

Exposures: The weekly data herein is important for the public asset managers with trends in mutual funds and ETFs impacting the companies with the following estimated revenue impact:

Jonathan Casteleyn, CFA, CMT

Joshua Steiner, CFA

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CHART OF THE DAY: Newsflash! Deflation Is a Headwind

Editor's Note: The following chart and excerpt are from this morning's Early Look written by Hedgeye CEO Keith McCullough. If you're tired of lousy market research and commentary we encourage you to subscribe today.

...How about this Chart of The Day? This shows you the classic go-to-move for my Old Wall buddies - back-end loading earnings and revenue estimates into Q3/Q4. Given what’s happened to macro markets in the last 3 months, good luck with that.

Less Compelling?

“Compelling reason will never convince blinding emotion.”

-Richard Bach

Particularly when I look back to those all-time US stock market highs, the botched “reflation” call, etc. in June/July, I can’t count how many times people told me in either meetings or in the media that there was compelling reason for the Fed to raise rates.

Now, “due to international developments” and stocks/commodities/yields crashing, the New York Federal Reserve calls a September rate hike, “less compelling.” Cool. So do Fed Fund Futures.

And I suspect that the oversold bounce we are getting in everything that crashed has largely to do with the catalyst socialized market participants beg for when they don’t get what you can’t print growth – moarrr central planning #cowbell!

Back to the Global Macro Grind…

It’s a good thing they bounced stocks/commodities from the lows. Imagine they didn’t?

Since a lot of people are blaming “China” for all of this, how did markets react to the Chinese cutting rates (again) a few days ago? That did nothing but scare macro markets. So… what markets really needed to see was moarrr – and in the last 24hrs they got it:

Rampant rumors that Mario Draghi is going to tell you he can do whatever it takes at Jackson Hole

Rumors that the Fed’s Vice Chair (Fischer) is going to double-down on the dovish Dudley comments (at Jackson Hole)

And since the Chinese can’t dominate the dialogue at Jackson Hole, they just “bought stocks” with State moneys!

Yep. Gotta love the Chinese central-planning dudes. They just went all Japanese on the stock market and bought it themselves.

Wouldn’t that be fun – if the Fed did the same?

Moving along… once markets get through this bounce (after the biggest move in volatility since 2008, it should be big, no?), I still recommend we respect/understand the following risks that caused many of the crashes (defined as price declines of 20% of more in anything that ticks):

#LateCycle Slowdown (locally and globally)

#Deflation (obviously)

#LiquidityTraps

#Volatility Asymmetry

#Credit/Profit Cycles Slowing

Apologies if I left a few out this morning.

Just in case you missed the last one, here’s the update (post 484 of 500 SP500 companies reporting Q2):

Revenues -3.8% YoY

Earnings -2.5% YoY

Old news, eh. How about this Chart of The Day? This shows you the classic go-to-move for my Old Wall buddies - back-end loading earnings and revenue estimates into Q3/Q4. Given what’s happened to macro markets in the last 3 months, good luck with that.

The other big problem (maybe the biggest of all since it’s so obvious in our model) is what I’ve been walking Institutional Investors through for the last 2-days of meetings in Boston and NYC – the GDP Comps for Q3 and Q4.

Comps, meaning comparative base effect or year-over-year comparison. Yes, they matter a lot more than some made-up PMI indicator with a random “lag.” And our call remains that on the US consumer side (toughest Christmas comps since 2007), it’s really going to matter.

Yep. Everything was awesome at $100-150 Oil, and it’s awesomer at $40. That makes a ton of sense. Even though US Rents are ripping to higher all-time highs and represents 24% of the Median US Consumer’s spending budget vs. Gas at 6%.

Oh, but that part of the country doesn’t matter. Right, right. And Consensus Macro hasn’t perpetuated inequality behaving that way either. How do “high-end” consumers “act” on 10-20% stock/commodity market draw-downs. Can’t wait for those compelling Christmas comps.

Our immediate-term Global Macro Risk Ranges are now:

UST 10yr Yield 1.99-2.19%

SPX 1 VIX 23.25-43.42 EUR/USD 1.08-1.16 Oil (WTI) 37.66-40.98

Best of luck out there today,

KM

Keith R. McCullough Chief Executive Officer

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08/27/15 07:59 AM EDT

Euro, Commodities and Yields

Client Talking Points

EURO

Big part of the bounce was rumoring from the Europeans that ECB President Mario Draghi is going to deliver the devaluation wood @JacksonHole – we don’t doubt that (FX market didn’t either, $1.16 EUR/USD became $1.13, fast) – that is the catalyst when growth is slowing, moarrr #cowbell.

COMMODITIES

Pretty much everything that crashed (China +5.3% this morning, WTI +4.2%, etc.) is “off the lows” as they say – don’t forget to understand/contextualize the bounces (and why we had the crashes). The CRB Index hit a new low yesterday of 185 (-20%, since May).

UST 10YR

Wasn’t it just U.S. Yields that bounced on the “risk on” trade yesterday; German and Swiss Yields popped (off their lows) too – stay with the #process and respect the range – UST 10yr Yield’s = 1.98-2.19% right now and a dovish Fischer (like Dudley) gets us paid Long Treasuries.

**Tune into The Macro Show with Hedgeye CEO Keith McCullough at 9:00AM ET - CLICK HERE.

Asset Allocation

CASH

70%

US EQUITIES

0%

INTL EQUITIES

0%

COMMODITIES

2%

FIXED INCOME

28%

INTL CURRENCIES

0%

Top Long Ideas

Company

Ticker

Sector

Duration

MCD

One of the ways that McDonald's is going to take market share back is through one of the most popular items on its menu—the Egg McMuffin. "I honestly believe that if there is a silver bullet, it’s all day breakfast for McDonald’s," says Restaurants Sector Head Howard Penney. "And I do believe they’re going down that road and they will do it."

Penney adds that we’ll probably know more about that at the November analyst meeting and what the breakfast potential will be. There’s obviously a lot of things that go around MCD doing breakfast (e.g. shrinking other parts of the menu, etc).

It was a very good week for those sitting behind the long-bond coming out of the FOMC minutes release on Wednesday. During a tumultuous 5-day stretch in which the S&P 500 fell over -5%, subscribers who followed our recommendation on TLT were sheltered from the market storm and gained almost +2%. Moreover, during the past month, TLT has gained +5.7% versus a -6.8% loss for the S&P 500 (a 1,200 basis point difference). In other words, it has paid handsomely to buck the consensus tide.

Three for the Road

TWEET OF THE DAY

QUOTE OF THE DAY

The phrase I can't is the most powerful force of negation in the human psyche.

Paul R. Scheele

STAT OF THE DAY

A study found that traffic congestion cost Americans $160 billion in wasted time and fuel last year.

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